Record new debt issuance, lack of revenue growth, increased acquisition activity, and the re-emergence of debt-financed shareholder returns have caused deterioration in credit metrics.

Corporations may not be as close to the end of their credit cycle as the deterioration in credit metrics would imply.

Much like the failures of over-levered U.S. consumers were the catalyst for the last credit cycle, evidence is mounting that over-levered governments are the possible tail that wags the dog.

A recent article on Bloomberg highlights a growing concern that we are reaching the end of the corporate credit cycle. Record new debt issuance, the lack of revenue growth, increased acquisition activity, and the re-emergence of debt-financed shareholder returns have combined to cause deterioration in average credit metrics. Credit investors are correct to be concerned. Layer on top the reduction in bond market liquidity seen by many as a red herring to tighter credit availability, and it is hard to argue against the idea that the end of the expansion phase of the corporate credit is near.

While declining credit metrics are a concern, are corporations really overextended? Exhibit 1 shows that, at 4.7x, high-yield leverage on average has jumped to an almost 20-year high.

Exhibit 1: High-yield leverage has jumped to a near-20-year high

Source: Columbia Management Investment Advisers, 07/15

The culprit for the half-turn (0.5x) increase in average leverage in the first quarter of 2015 is not a ramp up in debt, but a decline in earnings. The change in debt, while increasing, was in line with last seven quarters, while the EBITDA change was decidedly negative. The primary culprit was a -131.7% decline in energy EBITDA.

A similar pattern can be seen for average investment-grade leverage metrics; the shape is quite similar to high yield. Looking at the industry components tells a similar story. Industrials are flat to down over the decade, while energy average leverage is up over 1.0x since 2011. A conclusion is that not all industries are witnessing meaningful declines in credit metrics.

Corporations may not be as close to the end of their credit cycle as the deterioration in average leverage would imply. Exhibit 3 indicates that both gross leverage and interest coverage are trending up. This is normally and intuitively an inverse relationship. As leverage increases, so does interest expense, and thus earnings coverage of interest expense drops. However, since 2010, interest coverage has increased along with leverage. At the same time, corporations have recently taken advantage of low interest rates to extend debt maturities. This demonstrates that, to date, corporations have been reasonable in managing the capital structure, arguing that the end of the corporate credit cycle will not be self-inflicted.

The forecasters of corporate defaults currently agree. On an issuer-weighted basis for 2015, Moody’s and S&P see 2.7% and 2.8%, respectively. On a par-weighted basis, JPMorgan is calling for 3.0% in 2016, up from 1.5% in 2015. Our U.S. high-yield research team’s estimates call for 3.6% in 2015 and 4.9% in 2016 on a par-weighted basis. This is an increase from 2.6% and 3.3%, respectively — estimates made in September 2014 that were driven almost entirely by Energy.

But it is not all clear sailing. While some companies have been reasonable stewards of capital, others have not. Much like the failures of over-levered U.S. consumers were the catalyst for the last credit cycle, evidence is mounting that over-levered governments are the possible tail that wags the dog. A catalyst for the recent decline in oil was Saudi Arabia’s realizing the need to maintain market share to support longer term social expenses. The recent decline in other hard commodities is related to demand-driven concerns as the market questions Chinese policymakers’ ability to manage a ‘social capital market.” Eleven rate cuts followed by what appears to be a deflating of the equity market margin bubble does not support China adding to incremental commodity demand.

Also, of the 69 countries that we follow, 74% of the governments have witnessed an increase in debt as a percentage of GDP since 2008. A number of these countries have commodities as their main exports as well as a mixed record on market-pleasing financial reform. Are Greece and Puerto Rico anomalies, or will politicians and policymakers come to the realization that hard choices are necessary before their backs are against the wall? Unlike U.S. corporations, evidence suggests that some policymakers did not take the opportunity afforded by low U.S. and developed eurozone rates.

Given the importance of China in global trading, it is reasonable for the International Monetary Fund (IMF) executive board to consider the yuan for inclusion in the basket of currencies used to value Special Drawing Rights.

China is taking steps to improve the liquidity and transferability of its currency, but it is not clear to me that they currently meet the criteria for inclusion in the SDR basket.

If the Chinese government takes more substantial steps toward making the yuan fully exchangeable, allows interest rates to be set by the market, and allows free movement of capital, then their currency may evolve toward full reserve status over the medium to long term.

There has been much discussion and speculation about whether the International Monetary Fund (IMF) should include the yuan (or renminbi) in the basket of currencies constituting Special Drawing Rights (SDRs). SDRs were created by the IMF in 1969 to support the Bretton Woods system of fixed exchange rates. SDRs were initially worth 0.888671 grams of gold, which was also equivalent to one U.S. dollar. According to the IMF’s factsheet, a country participating in this system needed official reserves of gold and widely accepted foreign currencies to maintain its exchange rate. The international supply of two key reserve assets — gold and the U.S. dollar — proved inadequate to support the expansion of world trade. Consequently, the international community created a new reserve asset known as Special Drawing Rights. The SDR is not a currency; it is a claim on the freely usable currencies of IMF members. Holders of SDRs can obtain these currencies by voluntary exchanges between members or by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions.

However, Bretton Woods was disbanded in 1973 and the major currencies shifted to a floating exchange rate. The need for SDRs waned. Since then, the primary role of SDRs has been as a unit of account for the IMF, i.e., to value their own balance sheet and measure global trade, etc. Using a basket of currencies to value assets or trade flows helps reduce the volatility of valuation inherent to a single currency. The current basket includes the U.S. dollar, the British pound, the Japanese yen and the euro. The basket composition is reviewed by the IMF at least every five years “to ensure the relative importance of currencies in the world’s trading and financial systems.” The next review will occur by the end of 2015. Given the importance of China in global trading, it is reasonable for the IMF executive board to consider the currency for inclusion in the basket of currencies used to value SDRs. Today, even after an extraordinary issuance in 2009 following the global financial crisis, there are only about $320 billion of SDRs in existence. This may seem a lot, but it is tiny against the scale of global currency markets.

The use of the word “reserve” here is confusing. The SDR’s are supplementary foreign exchange reserves, but must not be confused with the common use of “reserve currency.” Reserve currencies are held in significant quantities by central banks and the private sector institutions as their primary reserve and method of purchase. A true reserve currency, such as the U.S dollar or the euro, is freely exchangeable and can be used in multiple transactions. SDRs can only be held by central banks, not private corporations or individuals, and can only be exchanged via the IMF’s SDR Department or on a voluntary basis with IMF member countries. New issuance requires an 85% majority, and voting is based on member country’s IMF quota rather than one country one vote. Therefore, the U.S. and Europe have significant voting rights. China is taking steps to improve the liquidity and transferability of its currency, but it is not clear to me that they currently meet the criteria for inclusion in the SDR. Even if China is meeting the criteria, the IMF’s own report states:

“In order to make a difference in any of these areas, the role played by the SDR would need to be enhanced considerably from its current insignificant level. Very significant practical, political, and legal hurdles would need to be overcome in the process.

“Expanding the volume of official SDRs is a prerequisite for them to play a more meaningful role as a substitute reserve asset… Even after the extraordinary allocation approved in 2009, total outstanding SDRs (204 billion) represent less than 4 percent of global reserves — well under the peak of 8.4 percent reached in the early 1970s. In part reflecting this small share, they are not actively traded.”

The IMF is looking at ways to increase the use of SDRs, but there has been very little progress. However, they are keen to include emerging market currencies in the basket. In isolation, a decision to include China in the SDR basket poses minimal threat to the status of the dollar as the world’s dominant fully exchangeable reserve currency. However, if the Chinese government takes more substantial steps toward making the yuan fully exchangeable rather than just widening the permitted exchange rate bands, allows interest rates to be set by the market, and allows free movement of capital, then we should assume the currency may evolve toward full reserve status over the medium to long term. I would welcome rather than fear those reforms, but we appear to be a long way from there.

The events of the past few weeks underscore the linkage between domestic political willingness to service debts and the likelihood of capital controls and/or eurozone exit.

Greece’s negotiations with its creditors provide lessons on eurozone creditor reaction functions, which will inform the market’s pricing of risk.

The jury is out as to whether business and consumer confidence across the region will be impacted by the spectacle, but we estimate that the impact will be limited.

The Greek economy is relatively small. Following the decision to bail out private creditors and replace their exposures with official credit, the country’s connectivity with the private financial system is extremely limited. But market participants have followed the twists and turns of the country’s negotiations with creditors with great interest, and for good reason — these negotiations provide lessons that will be generalized for the future. These lessons are not the morality tales peddled by pundits, but rather an understanding of eurozone creditor reaction functions, which will inform the market’s pricing of risk.

In 2012, eurozone leaders committed to the principle that domestic eurozone banking system integrity should not be compromised by concerns of domestic sovereign creditworthiness per se, and vice versa. The direct supervision of large banks was transferred from local regulators to the European Central Bank (ECB), and the regular Asset Quality Review process was set in motion. This move was made in reaction to the incipient financial Balkanization of the eurozone and the prospectively self-fulfilling eurozone financial crises of 2011–12.

Markets remained skeptical of eurozone leaders’ resolve to separate issues of sovereign creditworthiness and domestic banking integrity, suspecting that the negotiating leverage that could be mobilized on creditors’ behalf by binding both issues together would be too tempting for eurozone leaders to resist when it would advance their collective interests.

In declaring itself unwilling to continue to service its official sector debts, the Greek government has served as a test case for this de facto principle for the eurozone. Swiftly following this declaration of unwillingness to pay, capital controls were put in place that threatened the integrity of the already fragile banking system. The principle of separation between sovereign creditworthiness and banking system integrity proved as illusory as markets had anticipated, and media footage of cashless ATMs and distressed pensioners beamed across the world as proof.

From a market perspective there is little difference between the “bad outcomes” of a eurozone country implementing protracted capital controls and that same country leaving the eurozone. Both are associated with an initially significant negative economic shock, the requirement to write down bank equity meaningfully, the likelihood of senior creditor bail-in, and chaotic or unfunctioning domestic financial markets. With the second of the 19 eurozone countries going down the path of capital controls, efforts by eurozone policymakers to cast developments as unique will prove fruitless.

And so the experience of recent weeks serves to strengthen the market’s understanding of the linkage between domestic political willingness to service debts and the likelihood of capital controls, and/or eurozone exit. This lesson is independent of Greece’s continued membership of the eurozone: the market’s “bad outcome” has already been realized. Greece’s fate from here matters to us as citizens but less so as market participants.

How should markets now price eurozone financial assets? The unedifying political omnishambles that we have witnessed in Europe speaks poorly of the strength and coherence of its institutions. And the jury is out as to whether business and consumer confidence across the region will be impacted by the spectacle, but we estimate that the impact will be limited.

What remains is a “jump risk” that markets will struggle to price. The additional risk premia that investors require in order to insure against the prospect of a “bad outcome” of capital controls or exit is related to the joint probability of falling into an EU program and falling out with creditors. This is likely to be extremely small until it is extremely large. It is akin to going short an out-of-the-money put option with every purchase of a eurozone financial asset, with the option struck where domestic politics collides with creditor politics. Where this joint probability is minuscule, so will the risk premium demanded by investors.

It is worth recalling that the linkage between compliant politics and the risk that a banking system is turned off is a peculiarly European phenomenon. It is a product of political choices made in Brussels and Frankfurt. Choices made on the other side of the Atlantic have led to no such de facto linkage being in place in the United States. The contemporaneous debt default by the Puerto Rican government was not accompanied by the collapse of the Puerto Rican banking system and limits on cash withdrawals from ATMs. Similarly, the bankruptcy of Detroit did not lead to the suspension of Ford Motor Company stock. In his July press conference, ECB President Draghi expressed unhappiness over the choices made, appealing for the completion of a banking union and the introduction of a pan-European depositor insurance scheme. If he is to have his wish, we could soon see the end of the rolling eurozone monetary crises that we have witnessed for the past several years.

]]>https://blog.columbiathreadneedleus.com/greece-the-markets-odyssey/feed0Video: Three suggestions for fixed income investorshttps://blog.columbiathreadneedleus.com/video-three-suggestions-for-fixed-income-investors
https://blog.columbiathreadneedleus.com/video-three-suggestions-for-fixed-income-investors#commentsMon, 27 Jul 2015 12:30:52 +0000https://blog.columbiathreadneedleus.com/?p=7731In this video, Colin Lundgren, Head of U.S. Fixed Income, looks at conditions for today’s fixed-income investors. We may be cautious on the bond market overall, but don’t confuse that with selling all of your fixed-income holdings.

Greece won’t repay its debt without substantial forgiveness. Creditors will realize that repayment of some portion of the debt is better than nothing.

By once again avoiding the discipline of markets, Chinese leadership has only set itself up for tougher consequences in the future.

We need to see if Xi Jinping will reform China’s markets so they are more open and subject to more discipline and less government interference.

Greece – Latin America Revisited

In the 1980s major banks and governments which had lent too much money to Latin America found themselves in a never-ending series of debt renegotiations usually precipitated by a crisis in one or more of Mexico, Brazil and Argentina. Back in those days loans were not widely traded and banks pursued the accounting fiction that all of this debt was money good and would be repaid in full. Negotiations with debtor countries were often initiated just so these nations could pay interest on an ever mounting pile of debt. In the meantime, misery was the order of the day. Inflation rates reached hundreds of percent (even thousands of percent in Brazil) as countries printed money to fund budget deficits and devalued currencies to try to remain competitive in international markets. International lenders such as the IMF demanded austerity, reduced deficits and spending — often resulting in recessions and making debt ever harder to repay. It is a simple fact that a contracting economy cannot summon the resources to repay large debts.

This is easy to understand. Imagine an individual who lives beyond his means piling up credit card debt. Interest costs mount as the debt grows. Then the free spending individual loses his job and takes another with 20% lower wages. He was already living beyond his means and now repayment is even harder with a cut to income. Banks respond to late payments by introducing penalty interest rates which makes the debt even harder to service. The hapless individual has only two choices: Make more money to pay off the debt or seek forgiveness in bankruptcy court.

The government of a sovereign state can’t pursue bankruptcy, so debt forgiveness eventually becomes one of the few options to end the cycle of mounting debt and never ending renegotiation. In the mid and late 1980s, Latin American debt began to be traded and banks had to face the reality that debt was worth less than 100 cents on the dollar. The write-downs that followed hurt bank capital, which placed several of the big New York City banks in peril. Faced with anguish in Latin American countries and a troubled banking system, then Treasury Secretary Nicholas Brady devised with his team what became known as the Brady Plan. An element of this plan was debt forgiveness. Loans were exchanged for U.S. dollar-denominated bonds issued by Latin American countries. The bonds were backed by U.S. Treasury zero-coupon bonds purchased by debtor nations to serve as collateral. These “Brady bonds” became widely traded. With debt forgiveness in hand, many Latin American countries elected leaders who adopted more orthodox economic policies. In many cases, growth followed and debt was paid down.

This is not the first time that debt forgiveness was used to allow a nation to emerge from a crisis. In a fascinating article published on July 8, The New York Times argued that debt forgiveness has been a prominent feature of sovereign debt crises throughout the 20th century. Most notably debt forgiveness featured prominently in postwar Germany:

“As negotiations between Greece and its creditors stumbled toward breakdown…..a vintage photo resurfaced on the Internet. It shows Hermann Josef Abs, head of the Federal Republic of Germany’s delegation in London on February 27, 1953, signing the agreement that effectively cut the country’s debts to its foreign creditors in half. It is an image that still resonates today…it serves as a blunt retort: the main creditor demanding that Greeks be made to pay for past profligacy benefited not so long ago from more lenient terms than it is now prepared to offer.” *

My first prediction is that Greece will never repay its debt without substantial forgiveness. At over 300 billion euros (more than 177% of Greece’s GDP), the debt cannot be serviced by an economy that has contracted by 25% over the past five years and with unemployment holding at 25%. Indeed, the IMF has sensibly demanded that debt relief be a part of any rescue package.

Why give the Greeks a break? Eventually, Greece’s creditors will realize that repayment of some portion of the debt is better than nothing. Then, of course, there is the matter of the eurozone . Its birth was an effort to bring about European unity and end once and for all end the wars and squabbling. Markets agree with me. They rose on news of a new Greek bailout. However, this is only a band-aid. Debt relief must be part of the package and Greece must elect and empower more responsible leaders. There is more to come on this saga.

China — The mountains are high and the emperor is far away

This Chinese proverb is all too apt. China is a country with over 5,000 years of recorded history. Central authorities in Beijing (literally translated as “Northern Capital”) have long struggled to govern a such a vast, geographically diverse and densely populated land. Throughout history, China’s dynastic cycle would begin with visionary leaders/conquerors ushering in new reforms and subsequent growth, prosperity and flourishing cultures. As dynasties weakened, corruption would increase, both within the Emperor’s court and among the provincial officials dispatched by Beijing to keep order. Finally, social unrest, often reflected through peasants starving in the countryside, would result in the overthrow of a dynasty.

As far as I am concerned, the Communist regime in China today is nothing more than a modern dynasty. Enter Xi Jinping, China’s dynamic new leader who has launched a vast anti-corruption campaign. In addition to the convenience of jailing his political enemies, Xi is no doubt well aware that vast corruption has often spelled the end of Chinese governments. He is also reported to have studied the collapse of the Soviet Union which he believes began during the tenure of Leonid Brezhnev.

Xi is also worried about social unrest. Today’s unrest is not peasants starving in the countryside but unemployment and a slowing economy. This economy must support the swelling populations of Chinese cities in what is likely the greatest migration in human history from the farms to the cities.

Recently, China pursued a policy of propping up its markets to stave off a stock market decline that was well deserved given the outrageous valuations of Chinese stocks (think worse than 1999 in the U.S.).

My second prediction is that China is going to hit a wall if it stays on its current path. The banking system was never really cleaned up after the lending binge a decade ago. This is well documented in Carl Walter and Fraser Howie’s “Red Capitalism: The Fragile Foundation of China’s Extraordinary Rise”. By once again avoiding the discipline of markets, Chinese leadership has only set itself up for tougher consequences in the future. While the Chinse stock market is not large enough to matter to most Chinese, the move is still significant and worrisome. I view the news out of China last week as more important than Greece.

A growing, prosperous and peaceful China is in our best economic interest over the long term. Now we need to see if Xi Jinping is a reformer or just a more powerful version of Mao Zedong. As a confirmed “panda hugger,” a term used for fans of China, I am hoping that Xi will consolidate his power and reform China’s markets so they are more open and subject to more discipline and less government interference. I have always had a hard time buying the notion that seven guys in Beijing can control an entire economy. After all, the mountains are high.

Corporate earnings results for the second calendar quarter are likely to be a bit soft.

Despite relatively high valuations, investors seem willing to accept that better results are shimmering out in the future.

Near term, I would be more worried about stocks if earnings expectations were higher. Longer term, it also worries me that expectations are not higher.

Corporate reporting for the second calendar quarter started last week with a lead group of early reporters. Looking forward to the body of earnings season, I think results are likely to be, on average, a bit soft. And despite valuations that are on the high side relative to history, it just doesn’t seem that expectations are that high. In many industries, investors seem willing to accept that better results are shimmering out in the future, provided management teams can make a good case for what they are doing to position the company for that future. It is as if low interest rates have not only raised asset prices, but also made investors more patient.

In the information technology sector, the second quarter is usually stronger than the first, but channel checks of sales to enterprise customers have been on the weak side. A common longer-range theme is the transition from “on premise” software to software-as-a-service (SaaS). SaaS is more easily updated because it resides in “the cloud,” which can facilitate updates, maintenance and access, as well as provide other benefits. If big software providers like Intuit, Adobe, Autodesk, Oracle and Microsoft show progress moving their products to the cloud, investors may be more tolerant of low growth in the near term. As usual, companies in high growth areas like security software will have to track growth expectations. Meanwhile, China Internet companies will need to reassure investors that declines in the Chinese stock market don’t spill over into actual weakness in the overall economy.

An even starker transition phase is going on in the energy sector. With the collapse in global oil prices that started last fall, the sector has been in a period of adjustment. Energy analysts like to say that “low oil prices are the cure for low oil prices.” In the simple version of that maxim, oil prices drop, causing the more expensive supply sources to shutter, reducing overall supply. Prices rise and all is well. But cost structures are neither as simple nor as fixed as we may assume. So this will be another quarter where current performance is something of a footnote, while larger, longer-dated issues will be at the fore: Is production actually falling? How are management teams thinking about capital allocation? Have activity and pricing bottomed in energy services? And so on. In particular, it does seem as though costs have come down more than expected, which would tend to keep production higher and oil prices lower for longer.

The next round of quarterly conference calls will also give us a chance to take stock of the shadow the energy sector has cast on industrial stocks. Many industrial companies have had to come out with downward revisions to financial projections because the energy sector has greatly reduced the amount of goods and services purchased from industrial companies. In many cases, inventory destocking is compounding this slowdown. Also, the phrase “global capex pause” is circulating in the industrial sector. Add in slowing auto sales in China, and it is not surprising that investors are very eager to hear management teams discuss order trends and the general business outlook. Industrial stocks have underperformed the broader market by about 5% this year, but it’s not clear that expectations have hit bottom.

I would have thought the heightened macroeconomic jitters and slight steepening of the yield curve would be more of a benefit for the large capital market players. One of our senior financial analysts cautioned me on that upbeat interpretation, and so far the reports are lining up with the analyst (which I find reassuring). The “Grexit” saga seems to have caused investors to stay on the sidelines more than it induced them to go out and buy insurance via various derivative contracts with investment banks. The steepening of the yield curve, while in the right direction, has not had a chance to have much impact on net interest margins. On the bright side, all the M&A activity we have been seeing in the news did translate into a nice increase in business for investment banks facilitating the recent torrent of deals.

In the near term, I would be more worried about stocks if expectations were higher. But, longer term, it also worries me that expectations are not higher.

The loss of normal market access over the last two years is finally starting to impair Puerto Rico’s ability to finance structural budgetary gaps.

It’s difficult to determine ultimate recovery given dated financials, the heavy influence of politics and uncertainty about how various legal pledges will be treated under the fiscal adjustment plan or in court proceedings.

We believe that a debt moratorium/deferral is very likely given the Commonwealth’s precarious liquidity position. Investors should not rely on PR coupon payments for either current income or as a contributor to total return.

After nearly two decades of economic malaise, Puerto Rico’s fiscal situation is finally coming to a head. But the slow and deliberate pace of the Commonwealth’s downfall has left some investors asking, “Why now?” After all, the economy has been weak for years and the Puerto Rico’s fiscal position has always been precarious, even in the best of times. The simple answer is that the loss of normal market access over the last two years is finally starting to impair the government’s ability to finance structural budgetary gaps.

Economic and fiscal woes years in the making

Studies (including the just released Commonwealth-commissioned Krueger Report) show that Puerto Rico’s economic woes have been years in the making.* Corporations operating in Puerto Rico are subject to high costs of doing business — import prices are nearly double its Caribbean peers due to the Jones Act of 1920 and energy costs are substantial due to the island’s reliance on imported oil and inefficient operations at PREPA. Furthermore, the federally mandated minimum wage, which reached parity with the U.S. mainland in 1987, and generous welfare benefits force low-skilled workers into the informal economy, resulting in a very low 40% formal labor participation rate.

In 1976, well-intentioned federal tax policy exempted manufacturing companies located in Puerto Rico from U.S. corporate taxes, skewing economic activity and investment over the next two decades away from sustainable long-term industries like tourism and into high value manufacturing industries like pharmaceuticals, for which Puerto Rico held no natural competitive advantage. As such, when the U.S. Congress chose to phase out the tax credit between 1996 and 2005, the competitive advantage dried up, and so did manufacturing jobs. The tax incentive phase-out occurred at the same time as a significant run up in oil prices and was followed by the Great Recession, which further impacted the PR manufacturing sector. While the U.S. mainland began recovering in 2009, the Puerto Rican economy remained mired in recession, accelerating a trend of outmigration of disproportionately well-educated Puerto Ricans.

Years of faltering economics and weak fiscal interventions by the Commonwealth inevitably led to significant structural budgetary gaps. Due in large part to the island’s triple tax exemption, the Commonwealth was able to borrow its way out of such gaps. Consider that since the establishment of the Puerto Rico Sales Tax Financing Corporation (known by its Spanish acronym COFINA) nearly a decade ago, nearly all COFINA-backed bond proceeds have been used to close operating budget gaps. The consistent cycle of fiscal gaps covered by deficit borrowing has been enabled by regular political turnover — no incumbent governor has been reelected since 1997 — as politicians consistently favored myopic, ineffectual policies over prudent but politically difficult ones. With each new administration came turnover at every major administrative post, including executives of the enterprise systems, leading to policy discontinuity, inefficiency and the lack of a cohesive vision for Puerto Rico and its instrumentalities.

A turning point in market perception

The cycle of borrowing likely would have continued so long as the market allowed. However, traditional muni buyers began closing the spigot in 2013 as headlines of Puerto Rican struggles made their way into the popular press and investors began to understand their Puerto Rico exposures. State-specific funds that held PR for its triple-tax-exempt yield were on notice and could no longer pile in to Puerto Rican debt issues that offered attractive yields in a historically low-rate environment. What were left were primarily high yield muni funds and opportunistic hedge funds that demanded higher yield compensation to invest in Puerto Rico, evident in the Commonwealth’s 2014 general obligation issue, which priced with yields in excess of 8%.

The fiscal deterioration continued through this spring when the Government failed to place a $2.9 billion issuance needed to cover liquidity needs; the administration subsequently indicated the possibility of a liquidity induced government shutdown. Finally, in late June, the Governor declared that the Commonwealth’s debt is “not payable,” resulting in sharp price declines on Puerto Rican bonds. In response to the increasingly dire situation, the Government has taken steps to consolidate liquidity at the Government Development Bank (GDB), including enacting legislation that allows (read: forces) Commonwealth insurance funds to purchase $400 million in tax and revenue anticipation notes (TRANs) from the GDB. The measure also included a troubling provision allowing for a suspension of monthly GO debt payment set-asides – a key GO debt protection — if the GDB cannot successfully place another $800 million TRANs with private banks/investors.

Bondholders should expect missed payments

Over the next seven weeks, the Governor’s Economic Recovery Working Group, headed by the GDB President and aided by an army of consultants, will attempt to compile a credible fiscal adjustment plan that it hopes will bring creditors and potential liquidity to the table. But without the availability of Chapter 9 of the U.S. Bankruptcy Code, the process is inherently unstructured — even if the Commonwealth reaches agreements with several of its creditors, holdout risk is substantial, and there is currently no defined mechanism to cram down on nonparticipating creditors.

Current prices on PR debt now reflect, to a large degree, the market’s expected recovery on the Commonwealth’s bonds. However, it’s difficult to determine ultimate recovery at this time given dated financials, the heavy influence of politics in potential restructuring negotiations/proceedings, and uncertainty about how various legal pledges will be treated under the fiscal adjustment plan or in court proceedings. Many have argued that GO bonds are constitutionally protected and therefore won’t be disrupted, and indeed, the Commonwealth is “required” to pay GO debt service ahead of all other expenditures. However, under a liquidity crisis, these constitutional protections will likely break down under the guise of “police powers” — that is, if the Commonwealth must decide between paying law enforcement officers, for example, and bondholders, it will choose the former. The aforementioned legislation suspending monthly GO set-aside payments supports this notion.

We believe that a debt moratorium/deferral is very likely in the short-term given the Commonwealth’s precarious liquidity position. When a missed payment does occur, perhaps as early as August 1, the Commonwealth will surely find itself in court, and the consequent legal battles are likely to be numerous and protracted given the various parties involved and the myriad legal pledges on PR debt outstanding. Given this dynamic, investors should not rely on Puerto Rican coupon payments for either current income or as a contributor to total return.

]]>https://blog.columbiathreadneedleus.com/causes-and-consequences-of-puerto-ricos-sudden-decline/feed0Learning Center: Non-qualified deferred compensationhttps://blog.columbiathreadneedleus.com/learning-center-non-qualified-deferred-compensation
https://blog.columbiathreadneedleus.com/learning-center-non-qualified-deferred-compensation#commentsFri, 17 Jul 2015 18:14:31 +0000https://blog.columbiathreadneedleus.com/?p=7674Deferred compensation plans are not under ERISA – although they may have to fulfill certain ERISA reporting requirements — and therefore do not have the rules that an ERISA plan would have concerning participation requirements and contribution limits. Generally with a deferred compensation plan, taxation does not occur until constructive receipt. For participants in these plans, here are two points to keep in mind:

Point #1: Go beyond the deferral limits

Non-qualified deferred compensation (NQDC) plans predate 401(k) plans. But even with an available 401(k) plan, they offer executive and key employees a vehicle to defer compensation above the 401(k) salary deferral limits ($18K and for those 50 and older $24K for 2015). For employees in high tax brackets, this can be a valuable addition to the tax deferral tool kit.

Point #2: Pair NQDC with stock compensation to create a planning opportunity

Key employees likely receive stock compensation as part of their overall compensation package. The stock compensation is often a combination of Restricted Stock Awards (RSA)/Restricted Stock Units (RSU) and non-qualified stock options. Whether key employees receive RSA/RSU and/or NQSO, there is a planning opportunity to consider how to pair NQDC and stock compensation in a way that addresses the tax implications of stock compensation.

This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Threadneedle Investments does not provide tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.

A non-qualified deferred compensation plan is a contractual agreement to pay in the future for services rendered in the present. Restricted stock units and restricted stock awards are forms of grants of company stock; ownership by the employee is based on vesting requirements.

]]>https://blog.columbiathreadneedleus.com/learning-center-non-qualified-deferred-compensation/feed0From “Grexit” to “Grin,” but will Greece grin and bear it?https://blog.columbiathreadneedleus.com/from-grexit-to-grin-but-will-greece-grin-and-bear-it
https://blog.columbiathreadneedleus.com/from-grexit-to-grin-but-will-greece-grin-and-bear-it#commentsMon, 13 Jul 2015 16:15:40 +0000https://blog.columbiathreadneedleus.com/?p=7651After a weekend of long and often very bad-tempered discussions within the Eurogroup, the leaders of the eurozone have finally agreed to offer Greece a third bailout, with the European Commission confirming that Greece will benefit from approximately 86 billion euros of financing over the next three years.

Assuming the steps required in the coming days are met, the immediate bankruptcy of the Greek government has been avoided and the country will remain within the eurozone. However, the terms of the deal look to be very tough, and the deal will be seen by many Greeks as a humiliation. Given that the ruling Syriza party was elected on an anti-austerity mandate, and that voters rejected a much weaker reform package in the referendum, political upheaval may follow. Moreover, there is no debt forgiveness or debt write-offs for Greece, meaning that total Greek debt-to-GDP levels will remain unsustainably high.

The key points of the deal are as follows:

Greece will receive some 86 billion euros in bailout funds.

Before legal negotiations can take place, the Greek parliament must approve a range of significant reforms affecting value-added tax (VAT) and the tax base, pensions and other areas of the economy. The EU would like the reforms to be approved by the Greek parliament by Wednesday, July 15. This unusual approach is a response to the complete breakdown of trust between the Greek government and their European partners.

Certain eurozone national parliaments (most pertinently Germany) will then need to give the go-ahead before formal negotiations can begin over the specifics of the new bailout program. This could, in theory, be done by the end of the week, although this may prove to be easier said than done.

A 50-billion-euro asset fund will be created, chiefly to make sure that privatization commitments are kept. This will be run by Greece but supervised by Europe. Half of this fund will be used to recapitalise Greek banks.

The European Stability Mechanism (ESM) will provide an immediate 10 billion euros to recapitalize Greek banks, which are close to collapse.

A “haircut” or reduction of Greek debts will not be offered — i.e., there will be no debt forgiveness, which the German chancellor Angela Merkel has said is “out of the question.” Greece’s debts might be restructured to make repayment a little easier (e.g., by extending maturity), but only after Greece has introduced all of its promised reforms.

What happens if the bailout is not approved by the Greek parliament?

Prior to the deal being announced, the Eurogroup had warned Greece that its failure to enact reforms would result in the suspension of Greece’s membership of the euro. In the event of suspension, the exact length of the “time out” was not specified, but comments from the German finance ministry suggest it could have been as long as five years. However, this triggered further tension between the eurozone member states, with France’s President Hollande saying that a temporary exit from the euro area was not an option, and that the issue at stake was not simply whether Greece stayed in or out of the euro but “our conception of Europe.” President Hollande was supported by the Italian Prime Minister Matteo Renzi, while Germany continued to emphasise its refusal to do a deal “at any price.”

Wider implications

The key focus in the short term will surround the navigation of the immediate hurdles (i.e., Greek parliamentary approval followed by German parliamentary approval) and how long the banking sector can continue to provide cash to Greek citizens while emergency loans from the ECB remain frozen. All of these situations are urgent and any delay would increase the risk of a messy “Grexit” scenario significantly.

In the big picture, in agreeing to support this bailout process, Alexis Tsipras has effectively reneged on all of his party’s pre-election commitments and handed sovereignty for domestic policy to Europe. This comes at a time when the economic situation is likely to deteriorate further thanks in part to the newly prescribed austerity that he was so vehemently against. Against this backdrop, while the short-run risks of Grexit have declined, the risk that the Greek population begins to question the merits of euro membership must surely be increasing.

The implication for markets has been unclear through much of this saga, as investors have found it difficult to assess the direct costs or benefits of the different scenarios. Following months of indecision and reasons to be cautious, it is perhaps unsurprising to see a stark positive reaction to what is a “deal” full of pitfalls and contradictions. The big picture message is perhaps for citizens of Europe who might want to renegotiate the status quo with the establishment. From a position of weakness before, Greece’s economy now lies in tatters once again, facing the prospect of more austerity and outside control. For sure, Tsipras’ management of the situation could be called into question, but any budding protest parties elsewhere will think twice before taking on the elite.

]]>https://blog.columbiathreadneedleus.com/from-grexit-to-grin-but-will-greece-grin-and-bear-it/feed0Learning Center: Restricted stockhttps://blog.columbiathreadneedleus.com/learning-center-restricted-stock
https://blog.columbiathreadneedleus.com/learning-center-restricted-stock#commentsMon, 13 Jul 2015 15:02:33 +0000https://blog.columbiathreadneedleus.com/?p=7656Year 2002 may be best remembered for burst of the dot.com bubble. Stock valuations of internet startups with no revenue eventually crashed. But while many businesses failed, the stock price rout spread to solid high tech companies with revenue producing products, some of which were strengthening and expanding the internet infrastructure.

Cisco is a prime example

The stock price was as high as $80 per share before 2002 and as low as $14 afterward. Imagine the shock to key high tech company employees, for whom nonqualified stock options (NQSO) are a critical portion of their compensation, to find all of their options significantly underwater and potentially of no value before their expiration date.

Restricted stock to the rescue

The solution for many companies post that experience was to add Restricted Stock Awards (RSA) or Restricted Stock Units (RSU) into the stock compensation mix. Unlike NQSOs where the option must be in the money (the fair market value of the stock must be above the exercise price in order to have value to the option holder), RSAs and RSUs have an intrinsic value. The recipient is assured of receiving the Fair Market Value of the stock or units as of the vesting date.

Don’t miss these potential tax considerations

Here are two of the potential tax considerations you should keep in mind with restricted stock:

Unlike stock options, you don’t exercise RSAs/RSU to acquire the stock. When the grant vests, you automatically get the Fair Market Value as an addition to your compensation and you get the tax obligation that comes with it.

If you receive an RSA grant, if the plan permits, the recipient can elect to pay the tax liability at the FMV at the grant point rather than at vesting. This could be advantageous for employees in start-up enterprises. But there are risks of paying tax on a value that you may never receive.

This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Threadneedle Investments does not provide tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.

A non-qualified deferred compensation plan is a contractual agreement to pay in the future for services rendered in the present. Restricted stock units and restricted stock awards are forms of grants of company stock; ownership by the employee is based on vesting requirements.